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Diverse Crowd

This article originally appeared in the August/September 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.

Interest rates are on everyone’s mind. Positive employment numbers, signals from the Federal Reserve that it is entertaining winding down QE III, a recovering housing market, and improving consumer sentiment have sparked fear of inflation and pushed rates up. Fund flows emphasize the point. In June, for example, investors pulled nearly $10 billion from PIMCO Total Return Fund PTRRX, the largest outflows in the largest bond fund’s history.

That rates are on the rise isn’t surprising, if only because they’ve been so low for so long. The 2008–09 financial crisis left a real negative interest-rate environment in its wake thanks to a massive flight to safety and Olympian efforts on the part of policymakers to keep nominal rates low and liquidity high. In fact, one can make the point that among policy-makers’ goals was a reduction in governments’ real borrowing costs—not just keeping the “risk markets” (credit and equity) afloat. So, while central banks like the Fed (which doesn’t have an inflation target like the European Central Bank) don’t want runaway inflation, some inflation will erode real borrowing costs. Additionally, because the sheer presence of liquidity doesn’t necessarily lead to inflation—you need velocity (activity) not just money to make the economy go round—an increase in economic activity is likely to result in some inflation. Such inflation would be a sign that things are improving.

Indeed, things are improving, though perhaps not much and not far beyond the borders of the United States. The eurozone—the world’s largest economy—is still struggling with little evidence of near-term improvement. With this global sluggishness, there seems to be an upper bound on rates. Assuming away exogenous events like a war or supply shock, we will almost certainly not see rates climb to the double-digit levels of the early 1980s.

However, we may not see rates back down much either—the sheer supply of government debt is likely to keep them above recent lows. Given how low rates were at the start of the year, even a small percentage-point increase can be painful. Through July 5, long-term Treasuries, as measured by the Barclays Capital Long U.S. Treasury Index, were down 10.4%. Treasury Inflation-Protected Securities (which are long duration instruments and had sported negative nominal yields recently) were down more than 8%. The comparatively diversified but still Treasuryheavy Barclays Capital Aggregate Bond Index was down 3.5%. High-yield bonds, however, were up about 1.4%.

In a nutshell, duration risk has been bad; credit and equity risk has been good.

The Treasury yield curve has risen during this year—in both nominal and real terms.

In January, the yield on the 5-Year Treasury Constant Maturity Index was 81 basis points. At the end of June, it stood at 1.2%. If we use end-of-May, year-over-year CPI of 1.4% as a proxy for “expected inflation,” rates were negative for maturities less than five years. Negative real interest rates imply that investors are paying to lend in purchasing power terms. And we should emphasize that 1.4% is a very low number by historic inflation standards. It’s more than 100 basis points less than the 2.5% that many economists posit the long-term equilibrium number to be.